Sub-Prime Loans: Problem or Blessing?

Two recent op-eds in the New York Times by Bob Herbert and Paul Krugman were written to warn us about the dastardly deeds of greedy mortgage and banking companies.  According to Herbert and Krugman, the lenders tricked people into taking loans out on their homes that they could not afford to pay back.  These are called sub-prime loans.  Both writers argue in favor of making it more difficult for people to get such a loan by increasing the regulations related to sub-prime loans. 

You may be inclined to agree with these guys.  They're both smart people.  Surely they wouldn't be urging us to do something incredibly stupid, would they?   The people who were "tricked" into sub-prime loans that they later could not afford to repay are "hapless victims", right?  The banks and mortgage companies were surely "driven by greed".  Herbert says the marketing campaign by the banks was "If you can breathe, we'll give you a loan."  Those "high rolling" bastards.  How dare they make borrowing money so easy for the sub-prime borrower?  Let's pass a law so Big Brother can make sure that never happens again.  Right?

Let's see.

A sub-prime loan is not a less-than-perfect loan.  It's a loan made to a less-than-perfect borrower.  A normal loan is made to someone who has a good credit rating and enough steady income to handle the loan payment easily.  A sub-prime is made to a borrower who has less than good credit and/or not enough steady income to handle the loan payment easily.  People who go for a sub-prime loan are happy to have it because normally they couldn't qualify for a loan and they would like the money.  A sub-prime loan makes sense to the lender because they look at two things that are attractive about it:  1) the interest rate is high enough to attract a buyer (more on that next) and 2) the lender looks to the real estate to get their money back if the borrower can't pay. 

Why is there a loan buyer?  The lenders don't hold onto the loans they make.  They package them up and sell them.  The sub-primes are attractive loans to buyers because they have a higher interest rate. The buyers make more money.  And if the real estate equity is sufficient the loan has a very low risk of not being paid off.  Lenders get their money back from the loan buyer and can make a new loan.  The buyer holds the loan or sells off pieces of the loans to lots of investors.

So what went wrong?  Two things.

1) Real estate prices bubbled and loans were made against equity that wasn't real.  When prices came down, the equity disappeared and the loan was totally dependent on the borrower continuing to pay... and many of them couldn't. 

2) Many sub-prime loans were short term -- 2 to 5 years -- and when they came due, the equity in the real estate had disappeared and/or the borrower couldn't qualify even for another sub-prime loan.

Many sub-prime loans went into default and the real estate went into foreclosure.  The loan buyers had to write off the loans.  That makes them less than excited about buying more sub-primes and that dried up the sub-prime market.  And just like that it got harder  for someone who is less than perfectly qualified for a loan to borrow money.

In other words, the actions of the market have just done what the op-ed geniuses want to create some laws to do so this can't happen again.  But is that the right action?

Herbert writes about Dorothy Levy, a 79 year old who, with her husband, Dan, took out a loan against the equity on their home so they could pay off other debts and have some money to pay for Dan's illness.  Herbert says these two "hapless victims" were "persuaded to take out the new loan" by the unscrupulous "high-rolling" mortgage lender and now, 5 years later, her husband has died and she doesn't have the money to make the loan payments and she's going to lose her house. 

So here's the question:  Is it a bad thing that lenders can lend money to an unemployed old couple who are living on welfare by taking their real estate as collateral for the loan?  Maybe a better way to ask that question is like this:  Is it government's responsibility to keep you from making a bad financial decision?

Obviously, both Herbert and Krugman think that Big Brother should be more involved in keeping you from making financial mistakes.  But if the government has the power to keep you from getting what it thinks is an unwise loan, they will also have the power to keep you from getting what you think is a wise loan.   

Let's take another look at Ms. Levy, but this time let's pretend that there are regulations prohibiting a lender from loaning her money.

Ms. Levy does not get a loan that will force her to sell her house in five years.  She also does not have the money she needs to pay off high interest rate credit card debt.  That's not good.  All of her welfare income goes to pay credit card interest payments and hardly touches the principle.  These debts leave her without money to help her husband fight his disease.  Five years later, her husband died and all she has left is the equity in her house.  Unfortunately that equity has dropped like a brick and is about half of what it was 5 years earlier.  She has no money, loads of credit card debt and no one can lend against her house.  All she can do is sell it.  Except it might take a year before that happens and she's completely broke.  Herbert and Krugman are glad she can't borrow money against her house because they think that she can't handle it.  But she thinks she would be making a good investment by having the use of her home equity now.  Shouldn't it be her choice if there is a lender who will make the loan?

The issue is about who should have the final say over how we choose to manage our money, and nothing is more important in a capitalistic society than that.  When the government decides it can regulate who gets the money and for what, the little guys lose big.  For every Ms. Levy out there, there is an investor who leveraged their home equity with a short term low interest sub-prime loan, invested the money in more real estate or started their own business, and are now way ahead financially of where they would have been.   But you're not going to hear about them.  You are going to hear about the failures.

Oddly, these same writers are thrilled with the micro-loan programs going on in the third world, yet those loans are far more risky than sub-prime.  At least sub-prime loans were backed with real estate.  The micro-loans are backed with nothing but the good name of the people who get the loan since the people who get the loan are broke and living in total poverty.  Herbert and Krugman admire micro-loans because they provide capital for business development in poverty stricken areas and give people with drive the opportunity to work their way out of poverty by becoming entrepreneurs.  One in ten of the micros go bad, too, but you don't see Krugman and Herbert arguing they should be regulated out of existence.   

Yet Herbert and Krugman would prevent Ms. Levy from getting the money she wants, and perhaps that's best for her, even though she is begging for a loan.  But they will also prevent you from getting the money you need to start a new business, invest in a fantastic deal or send your kid to a great private college unless you are a prime borrower.  When bureaucrats decide to protect the little guy, it's the little guy who gets screwed.

Now go play!